Pricing in the US Pharmaceutical Industry

Brendt, Ernst R., Griliches, Zvi, NBER Reporter

There is a long history of measurement and analysis of productivity growth at the NBER. In recent years, several members of the NBER's productivity program have begun to focus on the measurement of price changes in the U.S. pharmaceutical industry as a way of assessing the accuracy of government price and productivity measurement.

Although the worldwide slowdown in productivity growth dates back about 20 years, we know surprisingly little even today about its causes. For some time, we have been suspicious of the reliability of official government statistics on growth in output and productivity, and we have conjectured that some of the reported slowdown may reflect difficult measurement problems. In particular, while government officials typically are able to obtain reasonably reliable data on sales, decomposing changes in sales into their price and quantity components is a rather difficult task. That is particularly true when the number of new goods increases, when forms of retailing change (for example, to increased mail order purchases), and when quality changes.

Given the fact that the value of sales equals a price index times a quantity index, any errors in calculating a price index imply corresponding errors in the quantity index. If inflation is overestimated, then growth in real output must be understated. But, how might we assess the accuracy of widely used price indexes, such as the Producer Price Index (PPI)?

We decided to audit a single industry in considerable detail. Although some of our earlier work focused on adjusting for quality the price indexes for personal computers,(1) we chose the prescription pharmaceutical industry this time (NBER Faculty Research Fellow Joshua Rosett was also a participant). We selected that industry in part because it apparently experienced a sharp slowdown in productivity growth in the 1970s. It also has seen considerable technological change (and therefore there are possibilities for measurement error); its pricing policies have been the focus of considerable public attention; and it has other interesting attributes (for example, it is heavily engaged in research and development, and enjoys protection under the U.S. patent system). Moreover, we were able to obtain microdata on a confidential basis from four major U.S. pharmaceutical companies.

Soon, though, we encountered a mystery. From January 1984 through December 1989, the Bureau of Labor Statistics (BLS) price index for prescription pharmaceutical preparations grew at an annual rate of 9.09 percent. We compared this official data to monthly price and quantity sales data on all 2090 prescription products sold by four major U.S. pharmaceutical manufacturers, accounting for about 24 percent of total domestic industry sales in 1989. Using procedures that mimicked those employed by the BLS (weighting a select number of products by the same factor over time, known as a Laspeyres index), we found that over the same time period, the four-company price index increased at only 6.68 percent per year. Moreover, when we used an index procedure that changed over time reflecting evolving market shares (a Divisia index), the aggregate four-firm price index grew at only 6.03 percent per year. Thus, the focus of our initial research was why the BLS price index grew approximately 50 percent more rapidly than our lower estimate.(2)

We were most concerned about the representativeness of our four-company sample. In cooperation with BLS officials, we obtained the four companies' records of the prices they had initially reported for the products sampled by the BLS. We learned that the rates of price increase for those products grew at an annual rate of 8.94 percent, virtually the same as the reported overall growth in the official PPI. Hence the discrepancy apparently was not caused by these four companies being unrepresentative.

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